FINANCIAL MARKETS: Regulatory proposals being put to Obama

As US President-elect Barack Obama prepares for the White House, policies are being aired on how to fix the world financial system and US economy. Patrick J. Byrne reports.

As US President-elect Barak Obama prepares for the White House, policies are being aired on how to fix the world financial system and US economy.

The World Bank is looking at the Spanish model of "dynamic banking", introduced in 2000, despite stiff opposition from the banks. The system required banks to progressively build up reserves against future hypothetical losses. When the sub-prime credit crunch hit, Spanish banks had 255 per cent coverage of non-performing loans, compared with the average European bank's mere 58.6 per cent.

It also means that additional costs borne by the banks limit their excessive growth in boom times, and lessens the need to cut back lending in a downturn. Instead of amplifying economic fluctuations, this process acts counter-cyclically to dampen them. (Wall Street Journal, November 10, 2008).

Robert Kuttner, editor of The American Prospect, argues that Obama has the opportunity to be a "transformative president" like Lincoln or F.D. Roosevelt.

Interviewed by buzzflash.com over his timely book, Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency, Kuttner said that the new President needs to come clean on the extent of the crisis.

"The crash on Wall Street is also the crash of free market ideology. [Obama] needs to explain to the American people why we got into this crisis - market fundamentalism - and how to get out of it [and] a much more pro-active role for government. And he needs to explain that government will do a better job of serving ordinary Americans when government is run by people who believe in its power for good, who are competent, and idealistic, rather than cynical."

Kuttner went on to argue for three key steps to be taken. He said:

"First, he [Obama] needs to do the financial rescue a lot better than [Treasury Secretary Henry] Paulson is doing. Banks have to be made to use the money to restore lending, not to pay out dividends and executive bonuses. We may have to nationalise a bank or two to get this done right.

"Second, regulate all financial institutions that behave like banks. Prevent them from engaging in excess speculation. Make them increase their capital to cover risks of loss. Turn the bond rating agencies into public institutions without conflicts of interest. All financial entities that create credit (and risk) need the same basic kind of regulation. Obama gave a terrific speech on this in New York last March 27.

Joseph E. Stiglitz, professor of economics at Columbia University and 2001 winner of the Nobel prize for economics, said that the financial system was supposed to allocate funds to investments with the highest returns and then to spread the risk from those least able to those most able to bear it. Instead, they have created risk by lending hundreds of billions to an inflated housing market, generating the worst housing bust since the Great Depression.

The first culprit he identified was the banks' abuse of the securitisation process. This involved banks selling and reselling mortgages in ever more complex instruments (some of questionable security) as a means to remove mortgage debt from their books so as to push through even more mortgages, regardless of the risk, to make even more profit.

Stiglitz's solution is: "A simple regulation requiring mortgage originators to put their own money at risk. In each transaction - say, 20 per cent of the loan amount - could curb these abusive practices."

Second, there is a clear conflict of interest in having ratings agencies being paid to rate new financial instruments by the finance institutions issuing these new instruments. Only with the connivance of the ratings agencies could these financial alchemists claim that the sub-prime mortgages could be transformed into golden products safe to be sold off to superannuation funds.

While Kuttner suggests turning the ratings agencies into public institutions, Stiglitz suggests new regulations such that: "Neither banks (including now investment banks) that can borrow from the Federal Reserve nor pension funds that are responsible for managing other people's money should be allowed to buy or sell risky and non-transparent products."

Third, Stiglitz argues that the system of how financial executives are paid has to be changed. "The present stock-option payment structure encourages chief executives to take actions that bloat the short-term reported profits of the firm, thereby inflating the share price, and everyone (except the executives in the know) eventually loses as a result.

"Their pay must be based on long-term performance, and they should share the losses, not just the gains."

Elizabeth Warren, Leo Gottlieb professor of law at Harvard University, and Amelia Warren Tyaig, a chief operating office and co-founder of the Business Talent Group, have argued for a commission for financial products similar to the US product safety commission.

Just as consumers would not tolerate the lack of industry regulations such that consumers faced a one-in-five chance of buying a toaster that would explode when switched on, nor should they be faced with mortgage, insurance and other financial contracts that are so convoluted that consumers cannot ascertain the true costs of the product - up-front costs, interest repayments and other conditions.

They write: "Of all the borrowers who were sold sub-prime mortgages in the past five years, nearly 60 per cent would have qualified for prime mortgages if brokers had offered them; the sub-prime mortgages carried so many rate escalators, prepayment penalties and other traps that even would-be prime borrowers defaulted."

They argue that "although the commission would have no hand in setting prices, it would be able to require that companies reveal the true cost of credit".

Asset bubbles

Eric Janszen, president of iTulip and a former venture capitalist, warns that within two years the US could be in the grip of a "modern inflationary depression".

He argues that for 25 years the US government provided subsidies - through tax subsidies, loan guarantees and loose regulatory policy - that created asset bubbles in the finance, insurance and real estate (FIRE) sectors.

He argues that it is now time to take away these subsidies, freeing up billions of dollars of capital for both the public and private sector.

Janszen says: "It's a chicken-and-egg problem: private industry can't bring more efficient cars (say) to market without significant infrastructure funding to build alternative fuelling stations, but meanwhile the delay in these technologies prompts the government to lavish even more money on old, inefficient industries in order to preserve jobs."

Massive infrastructure investment will be vital to the US private sector's investment in new technology, so that it can maintain its technological edge and help reindustrialise America.

- Patrick J. Byrne. This article is an extended version of the one that appeared in the printed News Weekly.